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Unsecured Creditor Wins Over Individual Ch. 11 Debtor

Jan. 29 — The absolute priority rule continues to apply in individual Chapter 11 bankruptcy reorganizations after the 2005 amendments to the Bankruptcy Code, the Ninth Circuit held Jan. 28, in a case of first impression on what it described as an “arcane but important” issue (Zachary v. Cal. Bank & Tr., 2016 BL 22570, 9th Cir., No. 13-16402, 1/28/16).

In a victory for unsecured creditors, Judge Andrew D. Hurwitz of the U.S. Court of Appeals for the Ninth Circuit followed sister circuits, overruling In re Friedman, 466 B.R. 471 (9th Cir. BAP 2012). The appeals court adopted the “narrow view” that the amendments to the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA)
of 2005 merely have the effect of allowing individual Chapter 11 debtors to retain property and earnings acquired after the commencement of the Chapter 11 case that would otherwise be excluded.

The Ninth Circuit's decision is important because there has been a split of authority among the bankruptcy courts regarding the application of the absolute priority rule to individual Chapter 11 bankruptcy cases. By adopting the “narrow view” instead of the “broad view,” the court follows most courts that have ruled on the issue.

Although its decision works a “double whammy” on the debtor, the court emphasized that its “task is not to balance the equities,” … “but to interpret the Bankruptcy Code.”

Creation of Absolute Priority Rule

Chapter 11 reorganization is for businesses or individuals whose debts exceed the statutory thresholds for Chapter 13 bankruptcy. An individual filing under Chapter 11 may confirm a plan of reorganization either with the consent of each class of creditors, or with a plan that is “fair and equitable” to each creditor class under Bankruptcy Code Section 1129(b)(1), (2), the appeals court said. The second method of confirmation is known as a “cramdown,”
and a debtor can cram down a plan only if it complies with the absolute priority rule in Section 1129(b)(2)(B)(ii).

The absolute priority rule is a “judicially created concept,” the appeals court said, which provides that a “dissenting class of unsecured creditors must be provided for in full before any junior class can receive or retain any property under a reorganization plan.” According to the court, the rule was adopted to prevent deals between senior creditors and equity holders that would impose unfair terms on unsecured creditors.

BAPCPA Amendments

Prior to BAPCPA, “every unsecured creditor must be paid in full before the debtor can retain ‘any property'
under a plan,” the appeals court said.

When Congress amended the statute in BAPCPA, it amended “property of the estate” to include not only prepetition assets, but also post-petition acquired assets and earnings from services performed by a debtor after the bankruptcy petition was filed, the court said. Congress added Section 1115, which only applies to individual Chapter 11 proceedings, and added to the Section 541 “property of the estate” definition property obtained by the debtor “after commencement of the case.”

Split of Authority on Issue

Under the “broad view” of the amendments to BAPCPA, an individual debtor is entitled to retain most prepetition and post-petition property and cram down a plan over an unsecured creditor's objection, the court said, citing In re Friedman.

The “narrow view,” however, holds that the BAPCPA amendments “merely have the effect of allowing individual Chapter 11 debtors to retain property and earnings acquired after the commencement of the case that would otherwise be excluded under Section 541(a)(6) & (7),” the Ninth Circuit said. Thus, an individual debtor can't cram down a plan that would permit the debtor to retain prepetition property that is not excluded from the estate by Section 541, but may cram down a plan that permits the debtor to retain only post-petition property, according to the court.

A split panel of the Ninth Circuit Bankruptcy Appellate Panel accepted the “broad view” in In re Friedman, but the Ninth Circuit rejected this view and adopted the “narrow view,” overruling In re Friedman.

Plan Violated Absolute Priority Rule?

Debtors David K. Zachary and his wife Annmarie S. Snorsky filed a Chapter 11 petition in 2011. The appellee California Bank & Trust was the largest unsecured creditor with a claim of nearly $2 million.

Under the debtor's proposed Chapter 11 plan, California Bank & Trust would be paid $5,000 on its claim, which would make it “impaired under the plan.”

California Bank & Trust objected to the plan, arguing that the plan violated the absolute priority rule under Section 1129(b)(2)(B)(ii).

The bankruptcy court agreed, concluding that the “‘absolute priority rule still prevails' in individual chapter 11 bankruptcies after the enactment of BAPCPA.”

The debtor appealed directly to the Ninth Circuit.

History of Rule Supports Narrow View

The Ninth Circuit said that it agreed with the Sixth Circuit in Ice House Am., LLC v. Cardin, 751 F.3d 734 (6th Cir. 2014), , , that Section 1115 and the new clauses in Section 1129(b)(2)(2)(B)(ii) that were added by BAPCPA define a new class of property that is exempt from the absolute priority rule.

The history of the absolute priority rule strongly supports the “narrow view,” the court said, noting that Congress repealed the rule in 1952, only to reinstate it in 1978. According to the appeals court, when Congress intends to abrogate a rule, it knows how to do so explicitly.

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